Why Is Debt-To-EBITDA Ratio Important For Self-Employed Borrowers

Why Is Debt-To-EBITDA Ratio Important For Self-Employed Borrowers

Why Is Debt-To-EBITDA Ratio Important For Self-Employed Borrowers

Self-employed home loan borrowers have always found getting home loans and mortgages a cumbersome process. The credit appraisal process requires a detailed analysis and evaluation of huge pile of financial documents and tax statements.

Banks or financial institutions, in order to determine whether you qualify for the home loan, must be able to assess the business income that has actually been distributed to you. This analysis also includes the assessment of the stability of your business income, and the capacity of your business to generate sufficient revenue to meet financial obligations.

For this, your lender will calculate a certain ratio. You will be expected to meet a fixed percentage of these stipulated financial ratio norms.

One such ratio is Debt-to-EBITDA ratio.

MakaaniQ explains why Debt-to-EBITDA ratio is calculated while funding self-employed borrowers.

Understanding debt to EBITDA

Debt-to-EBITDA (Earnings Before Interest Taxes Depreciation and Amortisation) is the ratio used to compare financial borrowings and earnings before interest, taxes, depreciation and amortisation. It is one of the most commonly used financial tools lenders use to estimate business valuations. It is used to ascertain the financial health and liquidity position of the borrower's company. It is one of the measures used to ascertain the ability of the company to pay off its debts.

A lower debt/EBITDA is a positive indicator because it means that the company has sufficient funds to meet its financial obligations. A higher debt/EBITDA ratio indicates that the company is heavily leveraged and that it may find it difficult to repay its debts. A high debt-to-EBITDA will also lead to a lower credit score. On the contrary, a lower ratio would imply firm's high capacity for more debt with a comparatively high credit rating.

This ratio facilitates the investor with the approximate time required by a firm or business to pay off all debts, ignoring factors like interest, depreciation, taxes and amortisation.

Understanding debt-to-EBITDA with an example

Mr A, the mortgage borrower has a company called ABC Ltd. The company had Rs. 10 Lakhs in debt (i.e. bank borrowings) and Rs 1 lakh in EBITDA in 2014. The debt to EBITDA ratio for 2014 is 10. In two years' time, the company paid off 50 per cent of its debt (i.e. Rs 5 lakh) and raised its EBITDA to Rs 5 lakh. This brings down the debt to EBITDA ratio to 1.

A declining debt-to-EBITDA ratio (over years) is good because it implies that the company is paying off its debt, and has grown in its earnings. Similarly, an increasing debt-to-EBITDA ratio means that the company is raising its debt more than its earnings.

Bank norms and limits

The debt-to-EBITDA is a financial metric that relates the debt/liabilities of the company to its cash flows by ignoring the non-cash expenses (i.e. depreciation, interest, taxes, amortisation). So, it is the cash flows used to pay off debts.

Banks and financial institutions consider a debt-to-EBITDA ratio of less than 3 as safe. Ratios higher than 4 or 5 are usually seen as a danger signal because this indicates that the company is likely to face difficulties in handling its debt. The borrowers' companies with high ratios of debt-to-EBITDA are less likely to be able to raise home loans and mortgages.

With inputs from Parul Pandey.

Last Updated: Thu Aug 10 2017

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